Fed Beige Book's Benign Economic Picture Contradicts Real Estate Reality

Yesterday's release of the Fed Beige Book lit a fire under the markets. The Beige Book painted a picture of an economy that was growing at a modest pace without suffering undue wage pressure or other inflationary impacts (except the usual jumps in food and energy prices).

The situation in the real estate sector was another story.

Residential construction is still in the doldrums. There were declines noted in new and existing home sales as well as falling prices and rising cancellations of new home sales. My expectation is that home builders are not yet out of the woods and ETFs like the SPDR S&P Homebuilders (XHB) will see more weakness in the near term. Yesterday's results for XHB, however, were anything but weak as investors, caught up in the euphoria of an overall benign read on the economy from the Beige Book, bid up shares in defiance of common sense. Maybe they didn't read the paragraphs on residential real estate.

The commercial real estate sector appears to be gaining strength and that gave a big boost to ETFs that focus on REITs like the iShares Dow Jones US Real Estate (IYR). Demand is strengthening, vacancy rates falling and office rents increasing. Those districts that mentioned commercial construction activity gave positive reports.

Still, interest rates are the highest they have been in a year and that has to have an effect on the REIT sector. Rates did weaken a bit yesterday, but remain close to their recent highs. One reason the REIT sector has prospered for the last few years is due to liquidity supplied through low interest rates, enabling commercial real estate investors to enjoy "phenomenal returns in the face of poor fundamentals" as Brian Lancaster, head of structured products research at Wachovia Securities, said last year. Furthermore, though residential real estate will be very much effected by the rise in rates, "commercial and industrial real estate, ... will be less affected because the acceleration of economic growth will bring about more demand for real estate, still ...the effects will be negative there. It perhaps will be most serious in the owner-occupied residential housing industry, which is not as strongly affected by swings in the world economy." This last quote is from Jeremy Siegel of Wharton.

As I mentioned in a previous post on REIT buyouts, a lot of real estate is being bought with the notion that there will be exceptional growth in fundamentals, i.e, increasing rents and property valuations. There is a good deal of optimism embedded in the current pricing structure for commercial real estate much as there was in the residential real estate market.

It is my view that we are at a risky stage in the REIT cycle with multiple cross-currents at work. We have yesterday's report of positive activity in the commercial real estate market and yet we have interest rates rising. Property prices and rents are relatively high and may not have much room to rise higher. REIT dividend yields are at multi-year lows. If you believe the stock market is a leading indicator, the charts of ETFs like IYR show trouble is brewing.

Comments

[Quaker:]

The markets today are overbought on a long term basis. That means just about everybody has a long bias. You can see this in the interpretation of economic statistics.

On the interest rate front, we're flooding the world with trasury bonds and trade deficits are monsterous. How is this anything but inflationary? How can this do anything other than eventually drive interest rates.
A friend from Colombia is telling me that it's almost impossible to export to the USA. The dollar fell from 2200 peso's to 1600 is 8 months. The same is true of oil. The Saudi's keep cutting production. Why? If they produce more oil, the dollar falls more. They maintain a dollar peg and inflation in Saudi Arabia is rampant.

The feds economists are what we used to call intellectual morons. Their calculations tell them inflation is low. Last night I bought three sandwitches at a pizza shop. They were $26. Sometimes a guys just gotta use a bit of sense. (it used to be common)

2007 Jun 14 09:34 AM

[LeeCarlson:]

Paul is right to some extent,..the treasury is flooding the world with bonds that are worth less each day, and trade deficits are enormous and have been for some time.
What it means is that the weaker dollar is forcing the oil producers to start to set prices by the Euro, not the dollar because the dollar is becoming worthless. This is already happening ! When the Euro first came out, it was pegged to the dollar and now the Euro is worth about 30 pct. more than the dollar.
The last few Presidents have listened to very bad advice. They agreed to Free Trade,..instead of Fair Trade. We cannot continue to import everything we need and pay with dollars that are worth less every day. That means imports are getting more and more expensive but our brilliant Fed. Reserve thinks this can go on forever !
On the plus side,..when the dollar gets cheap enough, jobs will come back to this country. This is one reason that oil is more expensive ! The dollar isn't worth much anymore and so it is being sold by a different standard, EURO's !
The Fed. thinks all they have to do is print more money to solve the problem but any first year student of Economics will tell you this cannot last long before the dollar won't buy anything from overseas and things purchased from this country are going to get less and less expensive for foreigners. !!
This country's products will become cheap again,..to foreigners, and they will be coming here for vacations , Disneyland, and winterhomes ! What we really need is a whole new bunch of people on the Fed. Reserve who really understand economics ! LC

2007 Jun 14 01:24 PM